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Hangover theorists

“We should have a recession,” Cochrane said in November, speaking to students and investors in a conference room that looks out on Lake Michigan. “People who spend their lives pounding nails in Nevada need something else to do.”

So the hangover theory, which I wrote about a decade ago, is still out there.

The basic idea is that a recession, even a depression, is somehow a necessary thing, part of the process of “adapting the structure of production.” We have to get those people who were pounding nails in Nevada into other places and occupation, which is why unemployment has to be high in the housing bubble states for a while.

The trouble with this theory, as I pointed out way back when, is twofold:

1. It doesn’t explain why there isn’t mass unemployment when bubbles are growing as well as shrinking — why didn’t we need high unemployment elsewhere to get those people into the nail-pounding-in-Nevada business?

2. It doesn’t explain why recessions reduce unemployment across the board, not just in industries that were bloated by a bubble.

One striking fact, which I’ve already written about, is that the current slump is affecting some non-housing-bubble states as or more severely as the epicenters of the bubble. Here’s a convenient table from the BLS, ranking states by the rise in unemployment over the past year. Unemployment is up everywhere. And while the centers of the bubble, Florida and California, are high in the rankings, so are Georgia, Alabama, and the Carolinas.

I have been surprised to see economists, particularly from Chicago and GMU, pushing Austrian views. It baffles me that economists as prominent and respected as John Cochrane would write such things.

Unfortunately, by the time this stuff reaches the popular press, including the New York Times, it becomes he/she said and a army of economists with differing opinions and viewpoints. Most readers and students of economics can’t parse the details of the science. Instead, economic views appear as plentiful and as equally valid as opinions about ice cream flavors.

The quotes you present make it seem there is and has been a class war going on for a long time now, only we’re seeing it played out in the open these days. I wonder why it is that people whom you have quoted never ‘need to do something else.’

Perhaps we should set aside the concept of a business cycle recession and begin to describe the characteristics of the credit cycle recession. The boon and bust of business or manufacturing of years ago has been replaced by the boom and bust of credit. Or perhaps both cycles have always been at work, lapping over each other and making and unclear picture.

Dr. Krugman, I enjoy your analyses (because they are easy for dopes like me to understand). Only the gifted can take complicated subject matter and make it simple. However, are you suggesting Schumpter and history are wrong? I get the prevalent theory but where is the math? How do you beat a liquidity trap with more debt in a 70% debt financed consumption based economy where 50% of the citizens can barely read or do math and a political environment of unsustainable social and defense costs? My view is at the end of the day, when fiat money is used in a fractional reserve lending system, the Politicos will destroy everything (as they have throughout time), no other result can obtain. Though my political views are inapposite of those you seem to profess, I believe Bush and his kind have destroyed the economic system in this country such that more debt will not solve the problem, perhaps defer, but no one ever beats a liquidity trap.

In a perfect world, recessions are not necessary, but given that investors, central banks, and governments will make mistakes, aren’t recessions (or at least fluctuations in growth rate) inevitable? They are the signals that someone is doing something wrong, just as a loss at a company tells the company that it had better change the way it is doing business. So, recessions are not a good thing, but they are a necessary and inevitable thing, given our inherent human flaws. Perhaps that was the point Cochrane was trying to make. Without more context, it’s hard to be sure.

But don’t crashes and recessions at least have a useful way of exposing and abruptly halting some of the ridiculous things that happen during booms, as with the famous Buffettism about the tide going out? At least the jig is up on the widespread chicanery that always accompanies booms, along with one of the biggest misallocations of capital in history. It’s hard to see how a “soft landing” would have purged the nonsense, especially since the recession of 2001-2002 didn’t do it despite all the apocalyptic talk at the time.

Hangover theorists like Peter Schiff, Ron Paul etc.. guys who have been permanently bearish about the economy and stock market have been getting way too much airtime recently.

Convinced by the recent economic developments are somehow proof of their “theory”; these “experts” have been mis-informing the public and crying out loud for abolishing the fed and public safety net.

Its disturbing when ordinary people are somehow convinced that recent economic issues is a reason to go back to gold standard and biblical justice system. Maybe you should consider devoting a op-ed columns to bust out the myths.

Paul, I know Casey Mulligan has invited a lot of derision (and quite justly for such a slip-shod presentation of ideas).

However, don’t you believe it is worth considering how the impending demographic falling-off-the-cliff (even China and Iran will have more 55+ than 16- population by 2020) might have impacted various asset valuation assumptions? I have been trying to formulate/ formalize this idea, and thought Mulligan’s idea that labor shortage might be a candidate. Only, I don’t quite believe that the labor shortage is now (in the present), but it is in the near future, and what are current valuations but earnings from future output discounted to the present? If the expectation is that in the near future a sharp demographic decline will sharply decrease the output, it has to be reflected in current valuations. Of course, severe illiquidity in the markets have also caused the effective discount rates to skyrocket (causing valuations to drop like a rock) – but hopefully the policy actions taken and in the pipeline will cause this rise to reverse .. but it will be hard to reverse the demographic falling-off-the-cliff.

I agree with your view that the ‘hangover’ theory isn’t nearly strong enough to explain what’s happening in the economy.

But it isn’t quite as bad as you say:

On your point 1 — why isn’t there unemployment when the bubble occurs? The hangover theorist would say that the growth of the bubble is VERY slow — giving he employment market time to adjust. When the bubble bursts, it happens VERY FAST. The labor markets are sticky and slow to adjust to the change — so there is unemployment. For them unemployment is always about a difference in the distribution of labor demand compared to labor supply. If employees are not needed in Nevada but there are people there, there is unemployment. But when the bubble is growing, it happens slow enough for people to move where the jobs are.

On your point2 — why is there mass unemployment? The hangover folks would say that there can be spillover effects from one industry to another. If one industry depends in some way (even very indirectly) on a certain type of consumer and that consumer is now unemployed, you will have difficulties in that related industry too. Hence it’s quite possible for unemployment to leak into other industries.

But I do think it’s trouble for the hangover theorists that the mass unemployment rates during a depression can get so high. And to explain why unemployment would be so high in states very disconnected from the housing bubble is hard for them. Mild unemployment across the board is expected (because of spillover effects), but not such massive increases in unemployment. Certainly not the unemployment we saw in the 1930s. That they couldn’t explain.

I think fundamentally what’s hard for hangover theorists theoretically is the idea that there can be a persistent desire for consumers/investors to want to hoard money. And when that happens, there has to be a drop in output. Maybe deep down they see that money hoarding will cause a drop in output, but they just can’t believe it can last that long.

To me, the fact that there still exists ‘schools’, ‘ideologies’, ‘-isms’ and incompatible – even inconsistent – theories is proof that economics is still not a science. Why can’t you economists agree on a general theory ?

In physics there have never existed such things as ‘Newtonism’ or ‘Quantumism’ or ‘Einsteinism’. At times when an established theory failed to explain the latest experiments, it was replaced by a better theory. Never by another ideology.

By the way, I googled for ‘Newtonism’ , ‘Quantumism’ and ‘Einsteinism’. They do exist – as religions.

Posner also recognizes the key role played in this crisis of financial people who just screwed up their assessment of risk. So, he’s not saying this because he uncritically extols everything produced by the private market.

Kind of surprised at your lack of reasoning here, given that I think you’re a pretty smart fella.

Re #1 – does someone have to NOT have a job to get a job in a hot industry? What about the guy working at MickyD’s for min wage who decides to jump ship into a construction job paying 2-3 times more? Money/resources will flow to the best deals. Let’s put it another way – do you expect that the only people buying hot stocks are people who had money sitting under their matress making no interest at all? Wouldn’t it be more likely that someone took money from their staid money market account?

Re #2 – velocity of money. As people are deleveraged from one industry, they can’t be absorbed into other industries at all once, and the ripple effect of people losing their jobs affects other (nearby) industries which affects the industries that are related to the nearby industries and so on.

The assumption that an economic system that relies heavily on free markets evolves so that some form of common good is always maximized in the long run is, in my opinion, a little naive.

Perhaps one day we will be able to simulate the behavior of different actions on a certain economic system, using reliable models, and tell which action is better, if any. That will probably contribute to showing that this idea does not hold any water, perhaps not even as a first approximation.

I don’t know where they get the “don’t feel like working” data, but I sense that they leave out a very crucial piece: the fact that “working” has speeded up, become more intense… in fact, has evolved to “overworking” in the past 5-10 years! Does anyone measure the amount of productivity now requireded on various jobs, vs. a decade ago? This reminds me of Ford’s assembly line, where it began to speed up, and people had to be paid much higher wages ($4/day vs. $1? if I remember right) because the work was so stressful.

Everyone that I know has reported that their job is faster, more complex and in most cases also now encompasses the job of some laid-of worker! So when they talk about people “not wanting to work”, are we in fact revealing that workers have finally reached their limit, and unemployment or marginal employment is preferable to the ravages of “the average job”? I’d love to know if there is data on this…

Wow. Could you demand that we absorb a little more of numbing economic theory on a Saturday morning?

From Groucho to St. Ignatius Loyola? Give me a break. We could spend the entire weekend alone debating the educational theory of the Jesuits.

Perhaps most stunning of all to the uninitiated is Keynes acceptance, agreement and apparent admiration for The Road to Serfdom. I suppose that we are talking about basic economic philosophies and presentation of economics on which perhaps there is little disagreement. If the disagreements are at the margins, I suppose they could still be quite dramatically different. Still, I don’t get it completely.

As to the basic premise of recessions being good for the economy, I think it is much like any other cyclic situation. Recessions are positive in that they deflate the economy. They are negative in that the deflation has some bad consequences.

It seems clear to me that that deflations are theoretically good when they occur naturally. On the other hand, in current circumstances, the elevation of prices through various speculations indicates to me that equipoise can be achieved only with a much steeper and swifter decline and a long, gradual return to stability.

I would think that in speculative inflationary situations the consequence is measurable. In other words, the higher they climb, the harder they fall. In addition, the long-term consequences can probably be calculated from the size of the peaks and troughs. We are not even at the bottom of the trough, so I do not see how anyone can make anything but a guess at our return to economic stability.

I would guess the multiple must be something like four or five times, which would return equilibrium, assuming we are near the bottom–though I can’t imagine that we are–sometime at least 16 to 20 months from now.

I would think anything earlier than that would be an astonishing recovery. Its architect would be worthy not only of a Nobel but also a prize consisting of the entire collected works of the Marx Brothers.

if an economy like the US takes an attitude of laissez-faire to a severe downturn like this one, xenophobia, racism, even fascism will prevail definitely. i can’t believe those guys in Chicago have never foreseen that.

I have a question on a related topic. My understanding is that price level rises during a bubble and falls during a recession. At the same time, rising price level or inflation is associated with lower unemployment, while falling price level or deflation is associated with higher unemployment. The causality often assumed is from price level to employment. So it is said that deflation causes high unemployment through various market mechanisms. This theory goes back to the Philips curve, an empirically observed law, which implies correlation but not necessarily a causality.

When we talk about deflation causing unemployment, are we not confusing correlation with causality? A decline in the price level after a bubble sounds like a natural tendency of a complex system to get back to a stable state. On the other hand, rising unemployment is what recession is, decline in economic activity. In this case, they go hand in hand, but not necessarily because one causes the other.

If deflation is really a necessary adjustment of an inflated price level, something that many people intuitively feel, especially if they live in New York City, could it not be that by trying to prevent it, we are actually prolonging it and thus making things worse. Like the extraordinary effort that we put in preventing forest fires, and thus building up the fuel for mega fires. Maybe we need to let some of the value burn too.

I think most people would agree that we ought to work toward a sustainable future. Bubbles create a sense of euphoria and optimism that we can indulge our insatiable appetites for excess without consequence. Even now people like the CEO of Goldman Sachs are saying that they don’t need to make any changes in the way they do business. If all we had was a short V recession and back to the next bubble we wouldn’t get the message. Sometime a real shock is the only thing that will cause us to change course in fundamental ways, and a deep and long recession is a real shock. Our way of doing things over the past several decades has become so ingrained that it may take a depression to get us out of it.

Do we want the Obama administration to spend a trillion dollars just to get us back on the gravy train again, the gravy train that enabled large wealth and income inequalities, humongous national and private debt, and wars all over the Muslim world? Or do we want to start working towards lower consumption, a stable economy and environment, and an end to war?

If the shock of a long recession or even a depression changes our attitudes about sustainability and conservation it will be worth it.

Bubbles inflate relatively slowly and are a result of a misallocation of capital, in this case, to housing. Bubbles pop relatively quickly, and as such cause umemployment
relatively abruptly. Our economy is interconnected and a popping bubble in one sector will cause unemployment in other sectors. In the case of a housing/credit bubble bust employment would be wide spread.
Thus, the hangover theory has merit even to a non PHD like me. It is not just common sense, it is a no brainer. To maintain that we can misallocate huge amounts of capital and have no pain is a fools game.